Vulcan Value Partners letter for the fourth quarter ended December 31st, 2015.

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Vulcan Value Partners - Portfolio Review

General

We materially re-positioned our portfolios into more concentrated positions in more deeply discounted businesses during the third quarter when we experienced meaningful market volatility for the first time in years. These decisions impacted our results in the third quarter and continued to do so in the fourth quarter. We are not pleased with our poor short-term performance, but, as you know, we place no weight on short-term results, good or bad, and neither should you. In fact, we have and will continue to willingly make decisions that negatively impact short-term performance when we think we can lower risk and improve our long-term returns. We encourage you to place more weight on our longer term historical results and a great deal of weight on our long-term prospects. Within this context we are gratified that all of our investment strategies are ranked in the top 1% to 5% of our peers since inception. In fact, Large Cap, despite a challenging 2015, is in the top 1% among its peers since inception.

A more detailed discussion of our results follows the table below.

Vulcan Value Partners

Our investment philosophy is designed to lower risk and produce exceptional returns over our five year time horizon. It is not designed to perform well in all market environments, and it is not designed to perform well over shorter periods of time. In fact, accepting poor short-term results is necessary to produce superior long-term results.

The current market environment reminds us of 2007. Then, as now, our short-term performance was poor. Then, as now, valuation levels were stretched, and what was working we simply did not want to own. In 2015, a narrow group of over-valued companies led the S&P 500 higher. Without the so-called FANG stocks (Facebook, Amazon, Netflix, and Google), the S&P 500 would have had a negative return. What else worked in 2015? The most expensive stocks trounced the cheapest stocks. The 50 highest P/E stocks in the S&P 500 returned 5.4%, while the lowest 50 P/E stocks returned -10.9%. Growth worked well too. The top quintile fastest growing S&P 500 stocks returned 12.9%, while the slowest growing returned -5.13%. The largest stocks did well, while smaller cap stocks did not. The fifty largest stocks in the S&P 500 gained 5.6%, while the smallest 50 declined 5.3%. Momentum worked while mean reversion produced awful results – the exact opposite of what has happened over the long-term. Over the last ten years, mean reversion, which is fundamental to value investors such as ourselves, produced a 7.2% annualized return versus 3.1% for momentum. In 2015, mean reversion produced a loss of 28.6%, while momentum produced a 2.4% gain.1

So, if we had thrown out our investment philosophy and bought the fastest growing, most expensive, largest companies that had gone up the most in price, we would have had a pretty good year. Instead, we methodically executed our investment philosophy, reduced risk and improved our long-term prospects. We allocated capital away from more expensive companies and added capital to more discounted companies with higher margins of safety. We responded to second half volatility by becoming more concentrated in our most discounted companies. The values of the underlying businesses we own grew even though prices declined. As a result, we have deferred returns, not lost them, and our prospective returns come to us with less risk because our price to value ratios have improved materially over the past twelve months. Said another way, our margin of safety improved, not just because of price declines, but also because of rising values.

In last year’s year-end letter we wrote:

“As we enter the New Year and compare our expectations over our five year time horizon to the previous five years, we are virtually certain that our returns will be lower. In the short run, anything can happen. In the long run, our returns are a function of two primary drivers. The first determinant is the underlying growth in the value of the companies we own. The second determinant is the discount to fair value that is available to us, which is the same thing as our margin of safety.

On the first count, the underlying growth in the value of the businesses we own has been consistently higher than the assumptions we use to value our businesses. Our estimated values have compounded at a mid-teens rate compared to our expectations of low double-digit value growth. Our companies are extraordinary, so it is not surprising that their value growth would be extraordinary as well. Our companies have produced large amounts of free cash flow, which has been reinvested wisely; they have grown their top lines, and margins have expanded. Going forward, we expect them to continue to produce ample free cash flow and to continue to reinvest wisely. In the aggregate, however, margins are closer to a peak than a trough. Top line results will muddle along with growth shifting from one region of the world to another, but the global economy is not firing on all cylinders and there is little prospect that it will be over our five year time horizon. So, the growth in the value of the businesses we own, while still positive and very attractive compared to inflation or bonds, will have to moderate over the next five years.

On the second count, we do not enjoy as wide of a margin of safety today as we did five years ago. Today, our weighted average price to value ratios across all strategies average in the mid-seventies. Five years ago, it was in the low sixties. As you know from our previous letters, our primary concern is reducing risk and protecting capital; not returns. As the margin of safety available to us has shrunk, we have reduced risk through greater diversification in our diversified strategies. Our returns are a by-product of reducing risk. A qualifying sixty-cent-dollar2 has a larger margin of safety and less risk than a qualifying seventy-five-cent-dollar. Stated simply, a seventy-five-cent-dollar that moves to a dollar, or fair value, generates less return than a sixty-cent-dollar that does the same thing.”

As this letter is being written, global equity markets are off to their worst start in recent memory with the S&P 500 down 9.0%, the Stoxx Europe 600 down 11.9%, and the Shanghai composite down 15.9%.3 The global economy remains weak. Europe is improving slightly, the U.S. is muddling along below its potential, the developing world is slowing sharply with some large economies such as Brazil in recession, and China is not only slowing but its headline growth is overstated. The dollar remains strong, and the Federal Reserve has begun raising interest rates in the U.S. Primarily due to the strong dollar, value growth for our portfolio companies was mid-single digits in 2015, better than the average company, but well below trend. 2016 looks like more of the same in terms of subdued value growth. Valuation levels, while improving, are a long way from cheap.

The silver lining to this somewhat glum outlook is that increased volatility and market declines give us the opportunity to continue to improve our price to value ratios, reduce risk, and improve our long-term prospects. As long-term investors with a five year time horizon, we want prices to decline more. We are not yet at a point where we are feeling bullish, but we are feeling better. We thank you for your confidence in us, and for your patient capital which allows us to execute our investment philosophy and compound our own capital alongside yours over our five year time horizon.
In the discussion that follows, we generally define material contributors and detractors as companies having a greater than 1% impact on the portfolio.

Vulcan Value Partners Large Cap Review

Vulcan Value Partners

We purchased three new positions in the fourth quarter, Intercontinental Hotels Group, United Technologies, and The Carlisle Companies. Intercontinental Hotels Group and United Technologies should be familiar names to our long time clients. We have owned both companies before, and both were excellent investments for us. Since we sold them, their values have remained stable in the face of economic headwinds, but their stock prices have declined, providing a margin of safety which allows us to own them again. Intercontinental Hotels Group, based in the UK, owns leading global hotel brands including Intercontinental, Holiday Inn and Kimpton Hotels. United Technologies is a large industrial company with leading global market positions in aerospace and elevators. The Carlisle Companies, while smaller than United Technologies, is also an industrial company with leading market positions in the aerospace industry, but its largest business is commercial roofing products. Both United Technologies and The Carlisle Companies’ results have been held back by the strong dollar, but the long-term outlook for their core businesses is excellent. All of these companies are competitively entrenched, produce high levels of free cash flow, and are extremely well managed.

We exited one position during the fourth quarter. We sold F5 Networks because we believed its competitive composition was declining. F5 Networks dominates the market for load balancers, which are used to optimize data traffic in large enterprises. We believe that the company will continue to dominate this industry, but that demand for its products will decline as more of its customers move data loads to the cloud where F5 Networks does not have a leading position.

There were no material contributors to performance during the fourth quarter. There was one material detractor.

Fossil Group has been a disappointing investment for us throughout 2015. We forecasted that 2015 was going to be a down year when we purchased Fossil and factored it into our valuation. It now looks like 2016 is going to be a down year as well, which we did not expect. While we would prefer to have been more accurate in our forecast for Fossil, we understand the reasons why and remain supportive of Fossil’s management team. Fossil has a very strong competitive position in the watch industry with global distribution and scale, strong internally developed brands, and a broad portfolio of third party brands. Fossil is the preferred partner for leading lifestyle brands including Michael Kors, Burberry, Armani Exchange, DKNY, Diesel, Tory Burch, Kate Spade, Adidas, and others. We think Fossil’s competitive strengths will enable it to compete effectively in the rapidly expanding wearables market. Fossil is investing heavily to participate in the wearables market, which is the main reason we expect 2016 to be a down year. If Fossil fails in wearables and retreats to traditional watches, it is extremely discounted. If Fossil is modestly successful in wearables, it is one of the cheapest companies we have ever owned.

We call attention to the fact that we are staying with Fossil even though its short-term financial results are challenged, and we are selling F5 Networks even though its current financial results are robust. The more important analysis is our understanding of each company’s competitive position. In the case of Fossil, we believe it remains intact. In the case of F5 Networks, we believe the competitive threat from the cloud poses unacceptable risks. We are human and we certainly could be wrong, but our long-term results are much more dependent on our analysis of the competitive position of our companies than on financial modeling and earnings forecasts.

Our price to value ratio improved by over 10 points in 2015 and ended the year in the mid-sixties. While we would have preferred better short-term performance in 2015, we are pleased to have been able to lower our price to value ratio by concentrating in our most discounted companies. In addition, the underlying value of the businesses in the portfolio grew. These improvements bode well for future compounding over our five year time horizon.

Vulcan Value Partners

Vulcan Value Partners Small Cap Review

Vulcan Value Partners

We did not purchase any new positions and exited five positions during the fourth quarter.

We sold Core Labs, Herman Miller, Inc., Jack Henry and Associates, Nasdaq, Inc., and Graco. All were good investments for us, and all were sold because they reached our estimate of fair value. We have owned the majority of these companies in the past. Nasdaq, Inc. deserves special mention. We bought it during the financial crisis and held it until the end of 2015. While we owned it, the company produced consistently high levels of free cash flow, grew its bottom line, and intelligently allocated capital. As a result, we enjoyed strong value growth as well as the closing of Nasdaq, Inc.’s price to value gap. We are grateful to Nasdaq, Inc.’s strong management team for their excellent stewardship while we were shareholders.

There were no material contributors and one material detractor to performance during the fourth quarter.

Fossil Group has been a disappointing investment for us throughout 2015. We forecasted that 2015 was going to be a down year when we purchased Fossil and factored it into our valuation. It now looks like 2016 is going to be a down year as well, which we did not expect. While we would prefer to have been more accurate in our forecast for Fossil, we understand the reasons why and remain supportive of Fossil’s management team. Fossil has a very strong competitive position in the watch industry with global distribution and scale, strong internally developed brands, and a broad portfolio of third party brands. Fossil is the preferred partner for leading lifestyle brands including Michael Kors, Burberry, Armani Exchange, DKNY, Diesel, Tory Burch, Kate Spade, Adidas, and others. We think Fossil’s competitive strengths will enable it to compete effectively in the rapidly expanding wearables market. Fossil is investing heavily to participate in the wearables market, which is the main reason we expect 2016 to be a down year. If Fossil fails in wearables and retreats to traditional watches, it is extremely discounted. If Fossil is modestly successful in wearables, it is one of the cheapest companies we have ever owned.

Nu Skin, also noteworthy, was the second largest contributor to performance in 2015 with just under a 1% positive impact on the portfolio, despite the fact that its stock returned -10.5% for the year. How can this be? Because we followed our discipline and purchased Nu Skin when its price declined and its value was stable. When its stock price rose and our margin of safety eroded, we reduced our weight. We size positions according to discount. The larger the discount the greater the weight and vice versa.

Despite a tremendous amount of work, Small Cap’s price to value ratio barely improved year over year and is in the upper sixties. Cash levels peaked in the second quarter, came down substantially during the third quarter but began to rise again during the fourth quarter. Even though Small Cap ended the year with good relative performance, we still lost money during the year. The number of qualifying investments available to us in Small Cap has improved marginally over the past 12 months, but the environment remains challenging. We would not recommend adding capital to our Small Cap program at this time.

Vulcan Value Partners

Vulcan Value Partners Focus Review

Vulcan Value Partners

It was a quiet quarter in terms of trading. We did not purchase any new companies during the fourth quarter. We did not exit any companies during the fourth quarter. Moreover, there were no material contributors or detractors during the fourth quarter.

For the year, Visa, MasterCard, and Boeing were material contributors and were also the top three contributors in the fourth quarter. For the year, Franklin Resources, Discovery Communications, Parker Hannifin, and Oracle were material detractors. During 2015, we reduced our weights in Visa, MasterCard, and Boeing as their prices rose more than their values grew. We increased our weights in Discovery Communications, Parker Hannifin and Oracle as their prices declined while their values remained stable.

The strong dollar had a negative impact on every company in Focus during 2015, and it was a headwind to value growth. However, the dollar is cyclical and, over time, companies can mitigate its impact. Adjusting for currency, the underlying fundamentals of our companies are much better than the headline numbers suggest.

Our price to value ratio improved by over 10 points in 2015 and ended the year in the mid-sixties. We became more concentrated going from 13 names to 11. By mandate we can hold as few as 7 names and as many as 14 names in Focus. While we would have preferred better short-term performance in 2015, we are pleased to have been able to lower our price value ratio by concentrating in our most discounted companies. These improvements bode well for future compounding over our five year time horizon.

Vulcan Value Partners

Vulcan Value Partners Focus Plus Review

Vulcan Value Partners

We finally had the opportunity to write option contracts during the fourth quarter. Volatility began to decrease in the fourth quarter of 2011 and has remained low for the last several years, which has made direct purchase and sale of stock more attractive. Recently, volatility has been increasing. If it continues, we might be able to use options more broadly. We use options to lower risk. We also make high, equity-like returns when option prices reflect higher levels of implied volatility. If exercised, these options give us the right to purchase stakes in companies we want to own at a lower price than the market price at the time the option was written. We would like for these options to be exercised and have set aside cash for that purpose. We employ no leverage. In effect, we are being paid double-digit returns on our cash while we wait for lower prices and a corresponding larger margin of safety. We also use options to exit positions. Generally, we write covered calls with the strike price being our estimate of fair value. As with our puts, we are being paid to do something we would do anyway at a given price.

We sold call options on Disney with the strike price equal to our estimate of intrinsic worth. We are earning a 10% annualized return on these options.

It was a quiet quarter in terms of trading. We did not purchase any new companies during the fourth quarter. We did not exit any companies during the fourth quarter. Moreover, there were no material contributors or detractors during the fourth quarter.

For the year, Visa, MasterCard, and Boeing were material contributors and were also the top three contributors in the fourth quarter. For the year, Franklin Resources, Discovery Communications, Parker Hannifin, and Oracle were material detractors. During 2015, we reduced our weights in Visa, MasterCard, and Boeing as their prices rose more than their values grew. We increased our weights in Discovery Communications, Parker Hannifin and Oracle as their prices declined while their values remained stable.

The strong dollar had a negative impact on every company in Focus Plus during 2015, and it was a headwind to value growth. However, the dollar is cyclical and, over time, companies can mitigate its impact. Adjusting for currency, the underlying fundamentals of our companies are much better than the headline numbers suggest.

Our price to value ratio improved by over 10 points in 2015 and ended the year in the mid-sixties. We became more concentrated by increasing our stakes in our most discounted names, and the number of companies owned in the portfolio decreased to 11. By mandate we can hold as few as 7 names and as many as 14 names in Focus Plus. While we would have preferred better short-term performance in 2015, we are pleased to have been able to lower our price value ratio by concentrating in our most discounted companies. These improvements bode well for future compounding over our five year time horizon.

Vulcan Value Partners

Vulcan Value Partners All Cap Review

Vulcan Value Partners

We purchased two new positions and exited three positions during the fourth quarter.

United Technologies and Woodward Industries should be familiar names to our long time clients. We have owned United Technologies before, and it was an excellent investment for us. Since we sold it, United Technologies’ value has continued to compound, but its stock price has declined, providing a margin of safety which allows us to own it again. Woodward is a similar story except that we have owned it in Small Cap for several years. United Technologies is a large industrial company with leading global market positions in aerospace and elevators. Woodward, while smaller than United Technologies, is also an industrial company with leading market positions in the aerospace industry, but it also has a large segment providing products to the energy sector. The majority of those products are related to energy production, so it is more insulated from commodity prices than is generally appreciated.

We exited Ashmore Group, Eaton Vance and F5 Networks. We sold Ashmore and Eaton Vance to redeploy capital into more discounted companies. We sold F5 Networks because we believed its competitive composition was declining. F5 Networks dominates the market for load balancers, which are used to optimize data traffic in large enterprises. We believe that the company will continue to dominate this industry, but demand for its products will decline as more of its customers move data loads to the cloud where F5 Networks does not have a leading position.

There were no material contributors and one material detractor to performance during the fourth quarter.

Fossil Group has been a disappointing investment for us throughout 2015. We forecasted that 2015 was going to be a down year when we purchased Fossil and factored it into our valuation. It now looks like 2016 is going to be a down year as well, which we did not expect. While we would prefer to have been more accurate in our forecast for Fossil, we understand the reasons why and remain supportive of Fossil’s management team. Fossil has a very strong competitive position in the watch industry with global distribution and scale, strong internally developed brands, and a broad portfolio of third party brands. Fossil is the preferred partner for leading lifestyle brands including Michael Kors, Burberry, Armani Exchange, DKNY, Diesel, Tory Burch, Kate Spade, Adidas, and others. We think Fossil’s competitive strengths will enable it to compete effectively in the rapidly expanding wearables market. Fossil is investing heavily to participate in the wearables market, which is the main reason we expect 2016 to be a down year. If Fossil fails in wearables and retreats to traditional watches, it is extremely discounted. If Fossil is modestly successful in wearables, it is one of the cheapest companies we have ever owned.

We call attention to the fact that we are staying with Fossil even though its short-term financial results are challenged, and we are selling F5 Networks even though its current financial results are robust. The more important analysis is our understanding of each company’s competitive position. In the case of Fossil, we believe it remains intact. In the case of F5 Networks, we believe the competitive threat from the cloud poses unacceptable risks. We are human and we certainly could be wrong, but our long-term results are much more dependent on our analysis of the competitive position of our companies than on financial modeling and earnings forecasts.

We ended 2015 with All Cap’s price to value ratio in the mid-sixties versus low seventies a year ago. As you would expect, this improvement is better than Small Cap but not as good as we experienced in our Large Cap portfolios.

Vulcan Value Partners

Closing

2015 was disappointing in terms of absolute compounding and relative performance, with the sole exception of Small Cap’s relative performance. However, as we say repeatedly in every letter, whether our performance is good or bad: we place no weight on short-term results, good or bad, and neither should you. In fact, we have and will continue to willingly make decisions that negatively impact short-term performance when we think we can lower risk and improve our long-term returns. We encourage you to place more weight on our longer term historical results and a great deal of weight on our long-term prospects. Our prospects have improved as our values have grown, and our price to value ratios have improved materially over the course of 2015, with Small Cap being the sole exception to this general improvement.

In addition, we continue to strengthen our organization. Bill Hjorth, who many of you know, and who has been at Vulcan Value Partners since the early days, is joining us as a partner. So is his colleague in Client Service, John Collier. John and Bill have made considerable contributions to Vulcan Value Partners, as has our Chief Compliance Officer Blevins Naff, who also is joining us as a partner. Last but not least, Jim Falbe, on our research team, is becoming a partner in our firm. Jim has strengthened our research efforts on multiple fronts, and we are looking forward to many more great things from him.

We greatly appreciate the confidence you have placed in us. We could not produce the excellent long-term results we have without intelligent, long-term focused client-partners. Thank you for your thoughtful support. We look forward to working with you throughout the New Year.

Sincerely,

C.T. Fitzpatrick
Chief Investment Officer